China's Rehypothecation Scandal In One Chart

Remember how small Greece was and how it wasn't relevant to US stocks... until suddenly it got close to breaking up the EU and the world's markets slumped. Remember how small subprime was? Remember how Lehman was not a 'big' bank?We hear the same "why would that impact us?" chatter now about the China rehypothecation scandal and we suspect the outcome will be just as dramatic a "whocouldanode" moment for many. The problem, as this chart so simply explains, is "more warrants than the volume of the underlying physical commodities have been issued in the repo business" and that is a problem for every foreign bank that was tempted into China's carry trade (which is "every" bank).

Simply put - the collateral that I promised you on my loan... I also promised to between 10 and 30 other people... but we're good right?

The “repo” business in commodities in China is similar to any other “repo” business in the financial markets. Generally speaking, the repo is a short-term FX funding vehicle, whereby a commodity owner first sells the commodity warrants issued by bonded warehouses (paired with an equal amount of short positions) to banks, then buys the package back from the banks in 3 to 6 months. It is a way for commodity traders/refiners to gain access to foreign banks’ balance sheets and improve liquidity efficiently.

The Qingdao situation alleges the issuance and pledging of more warrants than the underlying physical commodity. Were this to have occurred, foreign banks may be exposed to asset write-offs due to potential collateral shortages and/or losses. As a result, some foreign banks may have reduced or suspended their commodities repo business in China, and could be undertaking further investigation as to whether to make any suspension permanent.

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The initial reaction is likely to be to significantly reduce the exposure to different repo businesses and investigate whether there are any other multi-pledge issues in other deals. This is already happening in the market.

A further potential reaction, in our view, is for the banks to investigate the broader spectrum of their Chinese commodity financing deals (i.e. not just the repos or CCFDs, but the whole book) in order to clarify:

whether these deals are exposed to substantial underpriced risks;

whether the banks as a whole still want to continue the business;

if they choose to continue, what rules could be established and enforced.

Our base case is that, even if banks do not find any further cases during the investigation periods, they are likely to raise the bar for Chinese commodity financing deals in general, in order to broadly lower the exposure to this sector. This would occur via higher funding costs for the arbitrageurs, thereby slowly disincentivising repurchase deals and CCFDs, and resulting FX inflows.

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In a world where central banks have encouraged levered carry trades everywhere, a crack in the virtuous circle - such as we are seeing in China's fractional-reserve commodity financing deal business - will rapidly lead to a sell first (unwind first), think later mentality.

PBOC will likely continue to either lower 'liquidity requirements' so that they can lend more while also pushing down rates so that banks can lend more cheaply.

This will certainly be in part to make sure those who use copper as collateral can, in fact, either maintain or 'secure' their collateral.

There may be a day when China has an inevitable hard landing but the PBOC has a LOT of tools left. A hard landing could lead to social revolution... and think for a second... look at the lengths that the West go to prop up their economies... and how overextended they already are. Now consider what lengths the PBOC would go to in order to secure their ecnonomy and maintain order, and how yet underextended they are.

Point is nothing about what's right or what's fundamentally logical, but what is realistic -- and it's not realistic IMO that the PBOC lets anything significant happen from this any time soon because they have too many tools left and too much to lose.

PBOC is not the FED (or the EU) and has the advantage of looking at what the Fed & the EU have done and the mess they have caused. Let us hope they learned from it and come up with something new and refreshing, like maybe allowing some banks to fail.

Hey! Wait one second, Wang Fu. I have this paper right here, "Warranty Certificate of Ownership" that shows I own 5 tons of copper. See, it's written right here and even has the gold seal of BBbC, 'Better Business Bureau of China.' It's also signed by Ho Lee Phuk, the CEO.

The empty silo example is commonly used to illustrate the fraud behind fractional reserve lending and leverage. China does it quite literally... and uses fiat for that extra kick.

There's been a few articles on ZH recently about departure from USD in the Eurasia in favor of Yuan. I see no reason for excitement whatsoever. Dumping a questionable brand of toilet paper for a worse one... that has already been used. How's that a solution?

Sorry to say, but China, and copper are not the only country / banks / commodity to have UNLIMITED PAPER SUPPLY collateralizing their so called "liquidity fundamentals". This is how the real world functions lads. EVERYTHING IS REHYPOTHECATED by the paper that backs it, and the supply of paper is endless.

The much larger issue is how and when IT ALL unwinds. Copper is but a pimple on the ass of global rehypothecation. If it unleashes the Kraken of reality, so be it ....

Not so sure most of the paper copper is used by banks for collateral they really don't care if central bank steps in and hands them fiat instead, Foreign banks may get stuck with RMB instead of copper but that's not a huge problem right now, but could become a issue in the future. Short term the problem is Chinese companies will no longer be able to use this scam to build up debt and acquire FX. The result will be a sharp reduction in Chinese growth rate with a very high chance of it going negative when this is combined with other problems. Longer term the massive money printing of RMB(its really China's only option at this point) will cause inflation China and make RMB worthless overseas.

But that's the price you pay when you trust shady foreigners and try and bypass using the US dollar in trades and financial deals in order to prevent fraud.

Keep telling everyone to sell because the warehouses are empty. See how that works out for you. The Chinese will fill those warehouses or be executed. Copper is going to double. Tell the noobs at GS to leave China if they want to live. Their panicy charts and mumbo jumbo is laughable. Just a month ago they were telling everyone to sell becasue the warehouses were full. Now they are apparently empty and they are telling everyone to sell for that reason.